Sorry!! The article you are trying to read is not available now.
Thank you very much;
you're only a step away from
downloading your reports.

Lessons of a Trader


Risk Arbitrage involves buying the stock of a company being bought and selling the stock of the company doing the buying in an announced acquisition or merger. There is normally a spread between the actual prices and the eventual acquisition price that reflects the risk of the deal falling apart as well as some carrying cost. Yesterday we saw why this spread exists as the Department of Justice sued to block the First Data(FDC:NYSE)/Concord EFS(CE:NYSE) planned merger. With these new risks (that were largely unexpected) the spread widened dramatically.

We had a position not in the spread between the two stocks, but between their options: the options of FDC were much cheaper than those of CE. Once the deal closed, these options would merge. Our firm does not play direct risks, like the "risk arb spread", but derivative, secondary risks, like the volatility between the two.

So we lost money yesterday when the DOJ announced their opposition to the merger (at least for right now): even though we were not "long" the spread, the resulting impact to the options was negative. Even though a position in the options is a higher probability (return for risk) bet than directly buying the spread itself, which is what we look for, it is not without risk. When we factored in the risks, such as the possibility of the spread widening, it becomes a matter of valuing and trading the options separately.

The point of this is not to explain the details of our trade; it is to illustrate sizing a trade. From the outset of the trade we create various assumptions, conservatively estimating what can go wrong and what it will cost us if it does. Given our assumptions, the expected value (adding together the returns of each scenario multiplied by the probability of each of those scenarios) was very positive. We felt we could make three times what we could lose if our assumptions proved correct.

They weren't. The ugly scenario has played out, at least for now. So now we manage the position conservatively, assigning a somewhat higher probability than before that the deal will not close eventually, which leads us to value the options of each company separately. Our objective now is not to try to make all our money back, but to minimize the loss. In the worst case we estimate that we can lose .75% of our assets (from the outset of the trade) with a reasonable probability of breaking even, even if the deal does not go through.

A trader must take losses to make gains, but it is crucial to always have a favorable risk reward, never bet too much on one position, and manage the losing trades to minimize losses.
< Previous
  • 1
Next >
Position in FDC and CE

The information on this website solely reflects the analysis of or opinion about the performance of securities and financial markets by the writers whose articles appear on the site. The views expressed by the writers are not necessarily the views of Minyanville Media, Inc. or members of its management. Nothing contained on the website is intended to constitute a recommendation or advice addressed to an individual investor or category of investors to purchase, sell or hold any security, or to take any action with respect to the prospective movement of the securities markets or to solicit the purchase or sale of any security. Any investment decisions must be made by the reader either individually or in consultation with his or her investment professional. Minyanville writers and staff may trade or hold positions in securities that are discussed in articles appearing on the website. Writers of articles are required to disclose whether they have a position in any stock or fund discussed in an article, but are not permitted to disclose the size or direction of the position. Nothing on this website is intended to solicit business of any kind for a writer's business or fund. Minyanville management and staff as well as contributing writers will not respond to emails or other communications requesting investment advice.

Copyright 2011 Minyanville Media, Inc. All Rights Reserved.

Featured Videos